Fallacious Cure for Defective Economy

An exchange rate is a macroeconomic variable that represents a link between the national economy and the outside world. Moreover, the exchange rate determines the domestic price of goods and services, demand and supply, and the overall performance and state of equilibrium of the national economy.

However, the primary policy goal of nominal devaluation is to adjust the price of tradable goods and improve the position of the external sector. As always, the immediate objective of nominal devaluation is to reduce or eliminate the misalignment of the real exchange rate by generating a real devaluation that improves the international competitiveness of the country with the ultimate goal of enhancing the exports.

Nonetheless, the effectiveness of devaluation on the overall performance of an economy is a controversial issue among economists. There are those that are optimistic about it and others that hold a pessimistic view. The former argue that devaluation, by reducing imports improves the position of the external sector, helping the country’s balance of payments (BOP). However, the latter group believes that the increase in the domestic price of imported intermediate and capital goods will lead to higher operational costs resulting in a real contractionary output and inflationary effect on the domestic economy.

Since the late 1980s and early 1990s, most of the sub-Saharan African countries have been devaluating their currencies as a part of the Structural Adjustment Program’s (SAP) stabilising policies that are supported by international financial institutions such as the International Monetary Fund (IMF) and World Bank (WB).

Like many developing countries, Ethiopia has adopted a managed floating exchange rate regime to improve the external sector and the overall macroeconomic performance of the nation in general. It was also partially aimed at transferring the country’s exchange rate policy into one that is driven by market forces. Before the reform programme, the nation had followed a fixed exchange regime in which the Birr was pegged to the dollar at a rate of around two Birr between 1973 and 1992.

Since then the country has persistently devalued the Birr against the dollar. Seven years ago, it was by 16.7pc in which the rate jumped from around 13 Birr to more than 16 Birr for the dollar. The most recent is the measure taken by the National Bank of Ethiopia (NBE) a couple of weeks ago, which saw the Birr lose 15pc of its value.

Despite some positive outcomes, brought by the policy of some countries, devaluation in Ethiopia has been the cause of macroeconomic instability through its adverse impact on the performance of the external sector, output, inflation and investment.

There are reasons for this. First, it is implemented with the single-minded desire to secure loan advances from bilateral and multilateral creditors. Second, the government is not evaluating the effectiveness of the policy from the perspective of the nature, structure and development policy of the country. Third, the devaluation is only nominal not on real devaluation. Finally, the policy is not accompanied by an appropriate fiscal or monetary policy.

One of the adverse effects of devaluation on the economy is clearly manifested by its impact on the performance of the external sector. A chronic problem of the country has been the ever-increasing deterioration of general terms of trade (ToT), current account deficit, a balance of payment crisis and external indebtedness that will only be exacerbated by the devaluation policy.

However, the harmful effect of the policy on the external sector can be clearly observed when we compare the performance of the external sector in the post-devaluation period with the same pre-devaluation one. Thus, the current account deficit became more than double of what it was and the capacity of export earnings to finance import deteriorated from 75pc to a third of that on average.

Currently, the foreign currency reserve is too low and foreign exchange earnings have remained below three billion dollars. For these reasons, the country has been experiencing an ever-increasing foreign currency shortage and external indebtedness and dependence on foreign aid and debt for financing the BOP deficit in the post-devaluation period.

For better understanding, it is essential to analyse the reasons behind why devaluation failed to improve the competitiveness of the country in the international market. On the one hand, the export of the country is dominated by agricultural products that are characterised by high elasticity of price and low elasticity income in addition to being dependent on natural factors and thus erratic. Besides, the country’s volume of export commodities are insignificant, accounting for less than a percentage of supplies in the international market; as a result, the nation is a price taker. More importantly, the country specialises in exports that are against the comparative advantage and factors endowment theory of international trade. Thus, the devaluation hardly improves the volume of our export and boosts the foreign exchange earnings.

Earnings from exports is also another issue. Compared to imports, it is very low. In most cases, it is even outperformed by remittances. The gains that could be made from it will not make that much of a difference on the current account for a very long time.

Aside from this, there is the problem that devaluation brings to imports. The economy is characterised by the existence of high demand and low supply in which both domestic production and consumption is heavily dependent on imported raw materials and consumer and capital goods that have a high elasticity of income and low elasticity of price.

Secondly, the government wants Ethiopia’s economy to be industry-led, which will not occur without the engagement of the private sector. But the devaluation will significantly increase the operational cost of local investors for raw materials. Besides, the government is implementing a long-term development plan which has megaprojects in mind. The capital goods for these will now be expensive.

And since import is detrimental and less sensitive to a price increase, the economy would not respond to expenditure reducing and switching effects. Accordingly, devaluation alone is not the best policy measure for improving the performance of the external sector.

Above all the government should focus on policy measures that bring structural change to export and import. The government should implement strategic and policy measures that promote horizontal and vertical diversification of export towards manufacturing and the service sector by focusing on specialisation of export that enables the country to have a comparative and competitive advantage in the international market. In addition, the government is expected to create a conducive economic system that stimulates and promotes import substitution industries and develops trade regulations that strictly discourage import of luxury goods and services.

Another ill of the devaluation would be the inflationary pressure on goods and services. Ethiopia already has a double-digit inflation rate, which would only get worse because of the devaluation. Concurrently, this will be a burden on consumers. Domestic prices will be altered as the cost of production will increase and imported products would be more expensive.

Accordingly, devaluation has not brought the expected positive effects on the economy due to the above factors and has only resulted in increasing the domestic price of imported goods (making import expensive) and the cost of production. This has negatively affected consumption and the government’s ability to finance new projects, ultimately reducing real wage, retarding investment and employment.

One of the other measures taken by the central bank last week with the devaluation was to raise the interest rate by two percentage points to seven percent to fend the inflationary pressure of the devaluation by encouraging saving. Even though deposit interest rates can determine saving, for Ethiopia, as 80pc of the population is unbanked the measure could have little effect. It is also important to remember that people do not save to profit from interest rates but to safe guard their monies.

Contrary to the anticipated positive effects, the measure, by raising the cost of loanable funds, adversely affects productive private investment, thereby adding to the economic woes of the country.

As far as the economy is concerned, there is no legitimate reason that devaluation should bring about positive change other than hurting the Ethiopian consumer and damaging the economy.

By Kennedy AbebeKennedy Abebe is an E-banking business development officer at Wegagen bank. He could be reached at tsikal444@gmail.com.